Sunday, May 02, 2010

What A Difference A Day Made!

According to a once famous statement by the British Prime Minister Harold Wilson, a week is often a long time in politics. But when it comes to financial market crises we seem to follow a pattern more reminiscent of a line from the Dinah Washington version of an old María Méndez Grever song: "What a difference a day made". The day in this case was last Wednesday, at least for those of us here in Spain, since it was on Wednesday that the ratings agency Standard & Poor's downgraded Spanish Sovereign debt to AA from AA+. As a result the cost of insuring such debt using credit default swaps (CDS) surged at one point to a record 211 basis points according to CMA DataVision prices. Contracts on Greece and Portugal also rose sharply, with Greece climbing 42 basis points to hit 865.5, while Portugal jumped 20 to 406.

Standard & Poor's justified their Spain downward revision by referring to their medium-term macroeconomic projections. In particular the agency cited heavy private sector indebtedness (of around 178% of GDP), an inflexible labor market (they expect unemployment to remain around 21% throughout 2010, but then continue at a very high level for half a decade or so), the country's fairly low export capacity (Spain's exports only amount to around 25% of GDP) and the general lack of external price competitiveness. All these factors they feel are likely to mean that Spain will have low growth between at least now and 2016, a factor which will make the combined burden of private and public indebtedness much harder to service.

And despite the fact that Spanish Deputy Finance Minister Jose Manuel Campa stepped forward to say he was “surprised” by the move, arguing they are based on overly pessimistic growth forecasts, the fact is it is very hard to disagree with the S&P conclusions, as investors across the globe well understand. Even the EU Commission recently responded to Spain’s Stability Programme by stating that the growth forecast it contained was far too optimistic, and the IMF are even more pessimistic than the Commission.

In fact, it now seems that the present Spanish government seems to be becoming more and more isolated from Spain's financial and corporate establishment with every passing day. As Victor Mallet points out in today's Financial Times, "it cannot be often that academic economists use pictures of Omaha Beach, site of the bloodiest fighting in the 1944 Normandy D-Day landings, to illustrate their conclusions about one of the world’s medium-sized industrial economies", but this is precisely what the prestigous Barcelona-based Esade business school's latest economic bulletin did in their “H-Hour for the Spanish economy” editorial. “The diagnosis is very serious,” they said. “This is a highly indebted country with a damaged income-generating mechanism.”

Now even if one does not entirely go along with the whole analysis they offer of the roots and remedies for Spain's malaise, there can be no doubt that they now take the situation very seriously, even if one could lament that they did not begin to do so starting in August 2007, when the wholesale money markets first closed their doors to the increasingly toxic products that were being issued from within the Spanish banking system. The warning signs were already there, and were plain to see, although, unfortunately few inside Spain were able to do so. As a result, nearly three critical years have been lost, dithering around, large quantities of public money have been wasted, and what was a private sector external indebtedness problem has now been transformed, little by little, into a fiscal crisis of the state.

If the Spanish economy is really to be put straight, and not simply go straigh back and recidivise (after whoever it is who will do the "bailing out" finally does it), then surely one major priority during the coming national soul-searching process must be for public opinion leaders to find the ability and the courage to speak openly and clearly about the Spanish economy's "inner secrets", and the strength of character needed to publicly recognise problems in order to be seen to address them in a proactive and not a reactive fashion - to be out there in front of the curve, and not constantly trailing behind it. Put another way, it's high time Spain's bank and financial analyst community finally came out of the closet.

And if that all important international investor confidence is to be once more regained then it is important that those in the Economy Ministry are seen to be aware of the problems they face, and not simply reduced to the role of "marketing department" for a government which finds itself in ever deeper difficulty, caught between the rock of its own voters, and the hard place of the international financial markets. If you don't like having rating agency downgrades, then do something to avoid them before they inevitably come. But what was it Mr Zapatero was saying only yesterday, oh yes, he personally can see "signs" the Spain's economy Spain is at long last "improving", that the "worst is now behind us", or as Miguel-Anxo Murado so ironically puts it in the Guardian's Comment Is Free: "all repeat after me, "Spain is not Greece"". I'm not sure who it is the Spanish Prime Minister currently has interpreting the signs for him - it is certainly not Perdro Solbes, or David Vergara, or Jordi Sevilla, or indeed Carlos Solchaga - but it seems far more likely to me to be one of Spain's renowned Gypsy palm-readers than any reputable and internationally recognised macro economist.

In fact, as I have often stressed (and as Paul Krugman makes plain yet again here) Spain's problem is not essentially a fiscal one. Spain's problem is one of very high levels of corporate and household debt, and how Spain's banking system is going to support these during the long economic downturn and the ultra-high unemployment the country now faces, especially as a growing number of unemployed steadily lose their entitlement to unemployment benefit. The problem is not only that unemployment is currently running at 20%, but that benefits only last two years (plus an emergency six month flat rate 426 euro monthly payment extension), while many forecasts are now showing unemployment in the 16% to 20% range in 2013 or 2014. Just how are all these people going to continue to pay all those mortgages?

So it is not simply that "public sector borrowing is aggravating external debt and leading Spain towards high-risk territory". This is happening, as Spain's most high profile and most strategic export increasingly becomes government and bank paper, but this is the aggravating factor, and not the root cause. The principal reason why Spanish debt is steadily moving into high risk territory is the continuing state of denial to be found among the Spanish decision making elite, and the absence of any credible plan that is up to the magnitude of the challenge ahead. Confidence has now become the main problem, but not the confidence of those consumers who rationally decide to keep their money in the bank (to earn those very attractive 4 percent interest rates those banks who now anticipate having difficulty funding themselves in the wholesale money markets are offering) rather than going out and spending it.

The real issue is to be found in the confidence (or lack of it) those who Spain and its banks owe money to that the country (as a whole and not just the government) is going to be able to pay it all back. And in this context the sea change in mentality that Victor Mallet describes - assuming it is maintained - will be crucial. Those of us with rather longer memories - ones that stretch back to January for example - may wonder whether, once the immediate pressure is off, all that new found national resolve may not simply drift back into the mists from which it emerged, as has happened only too often in the past. Maybe the simplest and quickest way to help everyone feel comfortable that this was not going to happen would be to call in the IMF now, not becuase a bailout loan is needed yet, but as David Cameron is suggesting in the UK case, to carry out a "no holes barred" policy audit, so that everything which should be transparent actually is.

Who Really Likes Having A Dose Of Ebola

Of course the problems which became all too apparent on Wednesday went well beyond Spain. Along with the CDS prices, bond spreads widened all across the European periphery - with Spanish, Greek, Portuguese, Italian, and Irish yields all widening in tandem. Yields on Greece's two-year bonds briefly even hit an incredible 21%, following Standard & Poor's downgrade of the country's sovereign debt to junk status the day before.

All of this and more finally forced the EU’s hand, and officials had to go rushing to the microphone to reassure investors that Greece would soon be able to access an aid package, with German Chancellor Angela Merkel going so far as to state that talks about providing aid should now be accelerated.

Then the numbers started to be filtered out, and evidently they were much larger than many had been expecting. According to press reports IMF chief Dominique Strauss-Kahn told German policymakers that Greece might need EUR120-130bn over three years, a number which the German press quickly calculated would mean that the German contribution might then go up to EUR25bn.

Certainly, at the point of writing we still don’t know what the exact number will be - and it is not even sure they have decided yet - but the reality is that once the EUR120-130bn number is out there from an authoritative source, it will be hard not to hit it, if not exceed it.

Then followed the announcement that IMF staff have reached an agreement with the Greek authorities on a 3-year program that will include draconian fiscal cuts (of the order of 10pc of GDP) and a series of structural measures aimed at driving nominal wages lower, reforming the pension system and building better institutions. Thus, the message this weekend to investors is: stop worrying about Greece for the next three years; you can continue to speculate in the secondary market, but the Greek government will be fine. And debt restructuring with the private sector now seems to be off the table for, at least for as long as the Greek government stick with the conditions – which will obviously be the aspect to watch carefully going forward. And even if there is an eventual default, the main counterparty will be other European governments (and the taxpayers who back them) and not private bondholders.

On the other hand, Europe’s institutions have, at a stroke, opened themselves up to a large slice of what is known as “moral hazard”, since the implicit message is : what we are doing for Greece we'll do for any other Euro-zone country, if needed. So from this moment on, we are all in up to our necks, if not beyond.

This "historic moment" point-of-no-return dimension did not escaped the notice of Dominique Strauss-Kahn either, since following his meeting with German politicians he was at pains to stress the potential contagion affect lack of backing Greece to the hilt would have had on the euro and the rest of Europe in the days to come. “I don't want to hide behind a rosy picture. It's not easy,” he said. All this “ can also have consequences far away. We have to face a difficult situation. We are confident we can fix it... But if we don't fix it in Greece, it may have a lot of consequences on the EU.”

Highly respected US economist and Harvard University Professor Martin Feldstein went even further, saying that in his opinion Greece will eventually default on its bonds and he feared other euro-area nations may follow, most probably Portugal. “Greece is going to default despite all the talk, despite the liquidity package,” he said. Portugal's name is mentioned frequently these days, since although the government deficit and debt levels are lower in Portugal than in Greece and the Portuguese government has much more fiscal credibility than its Greek counterpart, when you add private sector debt to the public part the number is not far short of 300% of GDP, and in fact the underlying problems are very similar to those which are to be found in Greece.

But it isn’t only in the South the the EU has to worry, since probems in the East continue to fester. The Hungarian forint had a fairly hard time of it over the past few days, and had a two-day intraday loss 3.6 percent on Tuesday and Wednesday, its biggest such fall since March last year. At the same time the cost of credit default swaps on Hungarian debt rose 23.5 basis points to 240. The drop followed revelations from Hungary’s incoming Prime Minister Viktor Orban that the country’s underlying fiscal deficit had in fact been rather higher than the previous government had acknowledged. So contagion may now be also moving Eastwards, meaning that EU institutions may now increasingly face a battle on two fronts, since the wobbling won’t simply stop with Hungary, there is Latvia, Bulgaria and Romania to also think about (just to name the first three that come to mind).

As Angel Gurria, OECD Secretary General, said this week: “This is like Ebola. When you realise you have it you have to cut your leg off in order to survive...... it is contaminating all the spreads and distorting all the risk assessment measures. It is also threatening the stability of the entire financial system.”